A Social Club and Marcellus Shale

 

There is a type of tax-exempt which - on first glance - might not strike one as tax-exempt.

Let me give you an example: a duck hunting club.

Chances are it owns land, equipment to maintain the land and vehicles to traverse the land. At certain times during the year, members of the club will use the land to hunt.

What makes it tax-exempt?

The idea here is that - if an activity does not have a trade or business component - then multiple people coming together to conduct the activity should not change the tax result. Not every activity has a billionaire laying around who can singlehandedly pay for it all.

This is how we have tax-exempt status for fraternities and sororities, social clubs, golf clubs - and hunting clubs. In tax-jargon, they are referred to as 501(c)(7)s.

They are not taxed the same as the “true” tax-exempts - that is, the 501(c)(3)s. The (c)(3) is top-of-the-line: it does not generally pay tax, and donations to it are tax deductible.

A (c)(7) can only wish.

The reporting regime for a (c)(7) accounts for economic activity using three income buckets:

(1)   Member income

(2)   Nonmember income

(3)   Passive income, including investment income

Member income is straightforward: visit a golf club and this will be the dues, green fees, cart, restaurant and bar charges to club members.

Swap out nonmembers for nonmembers and you (generally) have nonmember income.

COMMENT: The word “generally” in the preceding sentence is intentional. The IRS does allow some free play with the member/nonmember dichotomy, as otherwise the separation would be unworkable. Consider, for example, a member who takes his/her spouse and kids to the club for dinner. It is doubtful that the kids are members, but it makes no sense to treat them as nonmembers. The IRS provided (some) relief decades ago in Revenue Procedure 70-17.

Here is another way a (c)(7) can vary greatly from a (c)(3): the (c)(7) pays tax on its net nonmember income as well as its net investment income. It is therefore an oddball tax-exempt: it pays no tax on member-related income (referred to as “exempt function” income), but it will pay tax on “nonexempt function” and investment income.

NOTE: There can be creative accounting for “net” nonexempt function income. Speaking for a friend here.

OK, so a social club - maybe, possibly, conceivably – might pay tax. Any other traps?

You betcha.

There are two big traps.

The traps are not about paying tax. They are about losing that (c)(7) status altogether. Lose that status and you are just another business taxpayer.

The first trap is nonmember income (including investment income) cannot exceed 35% of gross receipts.

This is why you must be accompanied by a member, and – even then – only so many nonmembers are allowed. It is also why you cannot have a wedding reception at a country club if you are not a member.

The second trap is a subset of the first: no more than 15% of trap one’s 35% can be from nonmember use of club facilities. 

I do remember years ago worrying about a client losing its (c)(7) from selling (some of) its land and generating capital gain. There is case called Santee Club where the court held that an incidental, nonrecurring sale of club property would not strip a club of its tax-exempt status. We may have squeezed everything possible from Santee Club to support our desired tax position.

I am looking at a recent (c)(7) case. There are not a lot of them.

Consolidated Sportsmen of Lycoming County (CSLC) was a nonprofit corporation in Pennsylvania. It obtained (c)(7) status in 1981.

CSLC owned 230 acres and sat on top of the Marcellus Shale formation.

Talk about winning the lottery. 

The members enjoyed camping, picnic areas, rifle ranges, skeet and trap shooting, canoeing, kayaking and swimming, among other activities. CSLC was the dictionary definition of a social club.

In 2011 it entered into an oil and gas lease granting extraction rights. CSLC received a signing bonus of $921,800, and extraction commenced December, 2016.

The amounts were significant:

While the dollar amounts were significant, CSLC members and officers spent minimal hours on mineral activities.

The IRS audited years 2016, 2017, 2018 and 2019.

Seeing the above numbers, the examiner proposed to revoke CSLC’s tax-exempt status.

CSLC had no intention of capitulating. It reasoned that a social club is defined by its activities. The officers and members of SCLC spent virtually all their time on social and recreation activities and almost no time on mineral extraction activities. The IRS was barking up the wrong tree by looking only at revenues. The effort associated with mineral extraction was minimal.

This went (no surprise) to Appeals, which agreed with the IRS.

Then off to Tax Court.

And we are walked through a history of social club taxation starting in 1916. The 35% test appeared decades later in a 1976 Senate Finance Committee report. The test however never made it to statute, Treasury Regulations or IRS rulings.

So why was the IRS clinging to 35%?

Had the Tax Court looked at this issue before?

While not codified, the test took on the mantle of Code-lite by repeated cite and use over the decades.

But CSLC was not challenging the 35% test head-on. It could live with 35%, but it argued that total member hours were as valid a measuring stick as total revenues.

The Court looked at the Code and had an issue with CSLC’s argument.

The Court observed that the Code does not provide a tax exemption for “members,” but it does for “clubs.” CSLC was narrowing its lens too tightly by focusing on member activities rather than club activities overall. A club can act through its members, but a club can also act through nonmembers (such as the contractor conducting the O&G extraction).

Let’s take this a step further. If the Court were to substitute hours for revenues in the 35% test, then it would also have to include O&G contractor hours. After all, the contractor had to employ people to produce the gas generating the royalties. Given the size of the royalty payments, the Court was … skeptical … that CSLC could keep the math below 35% - and the Court would still have to agree that hours were an acceptable alternative to revenues.

CSLC never provided the contractor hours.

The failure was ruinous. The history - what there is - of Section 501(c)(7)s 35% wordsmithing revolves around revenues. CSLC was presenting a novel methodology. It not only had to convince the Court that the methodology made sense, it also had to prove that it met the requirements of its own methodology. CSLC had the burden of proof.

It failed.

Absent an alternative measuring stick, the Court could and did look at revenues. There were years when royalties exceeded 50% of the club’s gross income. For those years it would be impossible to argue that “substantially all” of the club’s activities were social and recreational.

CSLC lost its (c)(7) status.

Our case this time was Consolidated Sportsmen of Lycoming County v Commissioner, T.C. Memo 2026-109.

The Savers Credit and Savers Match

 

I am looking at a tax change for 2027.

It is an expansion of an existing retirement provision, one that I very rarely see because of its income limitations. I like the intent, however.

Let’s talk about the retirement savers match, which is the post-2026 version of the retirement savers credit. The credit was created in 2001 in an effort to encourage low- and moderate-income workers to save for retirement. It provided a tax credit of 50% on retirement contributions of up to $2,000. The maximum credit per person was therefore $1,000 ($2,000 times 50%). The maximum for qualifying marrieds would be twice that amount: $2,000 for the two spouses.

There were two immediate issues with the savers credit. First, the income limitations were relatively low and - in addition – clumsy. For example, here are the income limitations for marrieds filing jointly: 

		50%	20%	10%
		Adjusted Gross Income Of
Married filing jointly		$48,500	$48,501 to	$52,501 to
		and below	$52,500	$80,500

Marrieds with AGI of $70 grand and contributing $1,500 to a 401(k) would receive a credit of $150 ($1,500 times 10%) – maybe.

The second issue was that “maybe”: the credit was nonrefundable. Say that your tax had already been reduced to zero (via child tax credits, for example). Your savers credit of $150 would now be worth $-0- because tax was already at zero and any excess below zero could not be refunded.

There is no surprise that the Aspen Institute estimated that only 25% to 30% of eligible taxpayers even claimed the savers credit.

Starting in 2027 the savers “credit” will change to a savers “match.”

While the income limitations remain relatively low, there are two main changes:

(1)  The credit is now refundable, and

(2)  The money will go to your retirement account, not to you via a tax credit. There is a de minimis exception of $100, in which case you can choose to treat the match as a tax credit on your return.

Congress replaced the 50%/20%/10% scheme with something closer to a sliding scale, with a slight bump in allowable income.

		Full 50%	Partial	No
		Match	Match	Match
		Adjusted Gross Income Of
Married filing jointly		$41,000	$41,001 to	$71,000
		and below	$70,999	and above

There are - of course - eligibility requirements:

• Be at least age 18 by the end of the tax year.
• Make qualifying retirement savings contributions.
• Not be claimed as someone else’s dependent.
• Not be a qualifying full-time student.
• Meet the applicable income requirements.

You can anticipate a bit of behind-the-scenes programming to make this work. For example, say that your employer offers a 401(k) and elects to accept the savers match to your account. Implementation is going to require time. Fortunately, the first returns to qualify for the match will the 2027 returns due on April 15, 2028. The old law is still in place for 2026 returns due on April 15, 2027.

COMMENT: Note that the money is from the federal government, not from your employer.

While an employer may accept the match, it is not required to do so. I presume that the match would instead go to an IRA in your name, as it cannot go to your employer-based plan.

BTW one does not need an employer-based plan to power the match. The match is looking at retirement savings, and a contribution to your IRA will work. In fact, one could fund a Roth IRA and still receive the savers match. Mind you, the match would be pre-tax (that is, like a regular IRA) and not Roth, but it is still free money.

Not surprisingly, rollover contributions will not qualify. The Code is looking for fresh retirement money.

There is also a clawback should someone abuse the intent of the match. Withdrawal of contributions generating a match during a “testing period” will allow the IRS to recover 100% of the match. Congress wants to reward long-term savings, not short-term binges.

Opportunity Zones and A Possible 2026 Tax Surprise

The 2016 Tax Cut and Jobs Act introduced a new provision to the Code - the qualified opportunity zone – sometimes called an “OZ.” I suspect that there was some humor while drafting the legislation, as here is the Code section:

         26 U.S. Code § 1400Z-1 – Designation

(a)      Qualified opportunity zone defined

For the purposes of this subchapter, the term “qualified opportunity zone” means a population census tract that is a low-income community that is designated as a qualified opportunity zone.

Yep: 140 OZ.

There are different technical terms in this area; For example, “QOZ business property” would include tangible business property; “QOZ business” would include an active trade or business where substantially all of the tangible property is QOZ business property; and “QOZ Fund” would be an investment vehicle – can be a corporation but usually a partnership – used to pool funds for investment in OZs.

For this post we will use the generic term “OZ.”

BTW, if you are presently in an OZ, there is a tax event in 2026 that you must be aware of. We will discuss the issue below.

Let’s discuss the following topics: 

     (1)          What are OZs?

(2)          Pre-2027 OZs

(3)          Post-2026 OZs

(4)          Gains reported through Schedule K-1

(5)          Another tax form

(6)          An example

What are OZs?

Introduced with the Tax Cut and Jobs Act of 2017, OZs were and are an effort to redirect private capital into historically overlooked economic areas. These areas (“zones”) were identified by the individual states and thereafter certified by the Treasury Secretary, a process which stretched into 2019.

There are – in general – two ways to invest in an OZ: a direct investment in a trade or business that operates within an OZ or in real estate located within an OZ; or an indirect investment via a fund which does the same.

Remember that an OZ’s purpose is to generate new investment. An intuitive example is starting a new business in an OZ zone. Buying an existing business can also work, but you must be willing to spend at least as much on new assets as you are spending to buy the existing assets.  Real estate can certainly work, but just buying an existing building or raw land will not suffice. The Code wants to see substantial improvement of the existing real estate. You are either renovating or building new if you want to OZ.

OZs have been compared to Section 1031 tax-free exchanges, but they actually operate quite differently. For example, to obtain the full benefit of a Section 1031, one has to reinvest (at least) the full sales price of the real estate sold. OZs are very different: one has to reinvest only the gain portion of the proceeds, not the total proceeds.

EXAMPLE: Let’s say you sell a building for $12 million with a gain of $3.5 million.

If you want a (full) Section 1031 like-kind exchange, you will have to invest at least $12 million (and meet other requirements) in replacement real estate.

If you want a (full) OZ, you will have to invest $3.5 million in an OZ-located business, real estate, or a fund that does that for you.

You see what powers the OZ: you must have a capital gain somewhere on your return. It does not matter what type of taxpayer you are. An individual, decedent, corporation, trust or estate will qualify – as long as you have capital gain as an admission ticket.

BTW your OZ investment must be equity. It cannot be debt back to you, much to the disappointment of tax planners nationwide.

And you have 180 days after the sale date to get the investment done. You cannot invest before the sale date. A Section 1031 can do that but not an OZ.

The driving force behind OZs are two potential tax breaks: one a tax deferral and the other an outright tax exclusion. These two can vary depending upon whether one invested in 2026 or earlier or invests in 2027 and later.

Pre-2027 OZs

(1)          The tax deferral

a.     Taxes on the underlying sale are not payable until December 31, 2026 (or when you sell the OZ, if earlier).

b.    There is a bonus for holding on to the OZ.

                                       i.     Only 90% of the gain will be taxable if you hold for at least 5 years.

                                     ii.     That changes to 85% if you hold for at least 7 years.

1.    COMMENT: I doubt that we will see many 7-years as the rules were not finalized until 2019.

c.     If you have a pre-2027, you will owe tax on December 31, 2026, unless you sold the property previously.

                                       i.     If you haven’t sold, you may want to start freeing-up cash for tax.

 (2)          The tax exclusion

a.     This one is tricky: all gain AFTER the original sale AND before December 31, 2047 is tax-free IF you hold the replacement property for at least 10 years.

                                       i.     Yep, the 2047 throws me too. I presume the 2047 has something to do with how the CBO scored the tax bill.

                                     ii.     If not sold by then, one steps-up basis in the property to its December 31, 2047 fair market value.

                                   iii.     Let’s be frank: all we are after is to hold for at least 10 years. 2047 is an after-thought, if it is even a thought.

b.    Example: You sell something in 2026 for a $1 million gain. You reinvest the $1 million and sell the replacement property 11 years later for a $2 million gain (totaling $3 million in gains over the transaction cycle - congrats). You will pay tax on the $1 million in 2026 – no one escapes 2026. You however will not pay tax on the subsequent $2 million, as you would have held the replacement property for the (actually, more than) required 10 years.

 (3)          Tax planners are a tricky lot

a.     Can one rollover the gain otherwise taxable at December 31, 2026 and defer the tax one more time?

                                       i.     In the preceding example, that would be the $1 million.

b.    The IRS was clear, blunt, and concise: NO!

                                       i.     No two bites at the same apple.

                                     ii.     The cite for the tax nerds is IRS Notice 2026-40.

Post-2026 OZs  

 (1)          The big change is getting rid of that one-size-fits-all-tax-recognition-date (of December 31, 2026). The new rules say that you will owe tax on the deferred gain on the 5^th anniversary of when you invested the gain.

a.     Makes more sense to me. I suspect that the original December 31, 2026 date had more to do with Congress being unsure whether the Code section would even be renewed.

 (2)          You still have the 10% gain exclusion if you hold the OZ for at least 5 years.

 (3)          However, there is no longer a 15% exclusion.

 (4)          Congress replaced that 2047 nonsense with a 30-year anniversary of the investment date.

a.     Once again, do not get caught-up here. What we are after is to hold for at least 10 years.

 (5)          Congress provided a specialized break for rural OZs.

a.     The 10% gain exclusion is 30% instead.

b.    Rural is described (generally) as 50,000 people or less.

Gains reported through Schedule K-1

One has 180 days to invest capital gains into an OZ.

How does that rule work when the capital gain is reported via a Schedule K-1?

If you sell an asset personally, you are (likely) aware of the sale and its sale date. You can more easily work with the 180-day window.

A sale through a passthrough entity (a partnership or S corporation, for example) can be more problematic. The passthrough may do an excellent job of alerting one of the sale and gain; it is equally likely that it may not. Take a partnership that extends its return, for example. As the tax preparer for a partner, my first knowledge of that gain may occur in September when the extended K-1 arrives. That would – without some relief – eliminate an OZ roll as a viable planning option.

So the Regulations provided relief.

First, the passthrough entity itself may decide to reinvest into an OZ. If so, then the 180 days begins with the exact date of sale. This would, of course, take the passthrough owners out of it.

Second, the entity may decide not to directly invest and instead distribute the gain to its passthrough owners. Each owner can decide whether or not to invest, as one owner does not bind another. However, if one does invest, when does the 180-day window start?

The passthrough owner has three options:

(1)          The actual date of the sale (of course);

(2)          The last day of the passthrough entity’s taxable year (most likely December 31);

(3)          The unextended due date of the passthrough entity return (most likely March 15).  

I am leaning toward Option (3) as my default.

Another tax form

There has to be a capital gain to power an OZ, so expect your return to include a Schedule D (where capital gains are reported) and perhaps Form 8949 (providing supplemental detail to the Schedule D).

Reinvest the gain into an OZ and you will add this beauty to your tax return:  

It has four parts, and you will attach (and update) the form each year as the OZ goes through its life cycle - from acquisition to disposition.

An example

Let’s walk through what happens depending on whether one has a pre-2027 or post-2026 OZ.

EXAMPLE: You have a $7.5 million sale with a gain of $1.5 million.

Pre-2027 

          (1)          You sold in 2025.

(2)          You bought the OZ in 2026.

(3)          The $1.5 million gain can be deferred only until December 31, 2026. Sorry.

(4)          There is no 10% or 15% exclusion, as you hit the gain recognition date (December 31, 2026) well before any 5- or 7-year anniversary.

a.     Had you sold and bought in 2019, however, you would qualify for the 7-year 15% exclusion.

(5)          However, the 10-year exclusion is still possible. You would keep the OZ, pay the tax in 2026 and hold it for (at least) 10 years. If you do, any further gain (that is, beyond the $1.5 million you already paid tax on) would be tax-free.  

Post-2026 

          (1)          You sell in 2027.

(2)          You buy the OZ in 2027.

(3)          Tax on the $1.5 million is deferred for 5 years. You will not pay tax until sometime in 2032.

(4)          You will get a 10% exclusion at the 5-year anniversary, meaning that only $1,350,000 of the gain will be taxable. (The 10% becomes 30% if you reinvest in a rural OZ).

(5)          Same as the pre-2027, the 10-year exclusion is possible.  

Closing thoughts  

There are some nice tax features to an OZ, but remember that we are talking about investments. Not all investments make sense to all investors. An OZ might appeal to a business owner recognizing a large capital gain upon the sale of his/her business. An OZ would not appeal to a well-maintained older CPA who sold his practice via a 5-year compensation-as-purchase arrangement.  

This is a longer-term investment. The Code is straightforward about this with its 5-year, 7-year and 10-year thresholds.   

Be sure to consider state taxes. We have discussed the federal tax considerations, but your individual state may or may not follow the federal rules.  

Do not overlook the routine tax reporting of an OZ. If you start an OZ business as a single-member LLC, for example, you will be filing a Schedule C with your annual personal return. If the LLC is instead owned by a partnership in which are a partner, then you will report the K-1 every year on Schedule E. Yes, the December 31, 2026/5-year/7-year/10-year stuff is also out there, but that is in addition to the routine annual reporting.  

And remember: if you already own an OZ, hopefully your tax advisor has been in contact about (a) whether the December 31, 2026 deadline matters to you and (b) if it does, how much it matters. If this is you, you likely have deferred taxes due for 2026.